We’ve gone back in time, so what’s next?

Say what you like of the youth of today, they might be even more prescient than the investment community when it comes to macroeconomic forecasting. Two years ago, while city folk were calmly asserting that the low rate/low inflation world would persist for years to come, their teenage children were already looking to the 70s and 80s for inspiration. Now, the nostalgia trend has reached a fever pitch, with Kate Bush at the top of the charts and Tom Cruise gracing our screens in Top Gun once again. Unfortunately, the throwback trend doesn’t end there. We are now firmly back in a world of inflation, union-driven strikes, economic malaise and even war. We are – to paraphrase another 70s cultural phenomenon – in something of a Time Warp, and a dizzying one at that. For those old enough, it will feel like déjà vu, for those too young to remember the 1970s, this environment will feel entirely new.

In amidst all this change and turmoil, we thought that it would be helpful to simply take a moment to pause, take stock, and explore what this situation means for investors. Boiled down, that means answering three key questions; is inflation here to stay, will we have a recession, and how bad will it be? In the second section of this commentary, you’ll find a deeper exploration of the ways in which we’re allocating capital accordingly.

This is perhaps the least controversial and the easiest question to answer; in a word, yes. Or at least, it’s highly likely. It’s worth factoring in an outside chance of a deflationary environment driven by severe asset price deflation if policy remains too restrictive for too long, but that’s less likely. The reasons for short term inflationary pressures are clear enough for anyone to see, war in Ukraine, supply and demand imbalances in the post pandemic economic recovery, and logistics disruptions from China’s intensive lockdowns. Were it just for these factors, we would expect inflation to ease considerably over the next few months, but that’s not the case. The two things that kept inflation so low over the past 40 years were minimal wage growth and globalisation, now, both have gone into reverse. We have moved from a virtuous circle where innovation meant that people needed less money to live well, to a vicious one where the cost of living is rising, and wages can’t rise fast enough to meet consumer needs. What’s more, the government spending genie seems to be well and truly out of the bottle. Millennials now make up the dominant proportion of the vote in key economies, and they are far more friendly to tax and spend economics than their baby boomer forebears.

The caveat to all of this; is that the hyperinflation scenario is far less likely. Even if there were clear economic drivers behind it, mathematically it would be hard. For us to see the same inflation figures we’re seeing today in a year’s time, we’d need oil to go up by something like another 40%. That being said, we think that the days of sub 3% inflation are very likely to be behind us for the foreseeable future.

The bad news is that we do think a recession is likely, although a small consolation might be that it could help with the current upward pressure on inflation, which would ease the pathway for looser monetary policy. Looking broadly, there is no doubt that the growth data are showing signs of a slowdown. Whether you’re looking at traditional metrics like US PMIs or at the more esoteric datasets like CFO capital expenditure expectations, they’re all pointing downwards (albeit not yet severely). Even if we did see a sudden positive development - say an easing of the conflict in Ukraine or the end of China’s zero Covid policy - this recession is now so well signposted that it is likely to become self-fulfilling. In fact, it’s very unusual for there to be such widespread consensus around an economic downturn, and it’s also quite unhelpful; CFOs staring down the barrel of a recession are likely to cut back on spending, deepening the economic slowdown as well as bringing it forwards. There are already signs of this contraction feeding through into the labour market; we have seen more than 28,000 job losses in the US tech sector this year so far. As we head into earnings season, we’ll get a clearer picture of the extent to which the weakening economic environment is starting to hurt corporate profits.

At this point, the risk is balanced. The best-case scenario would be The Fed managing to engineer a “soft-landing”, where they’re able to keep inflation under control without causing severe damage to the labour market or broader economy. Unfortunately, even Tom Cruise’s Maverick Mitchell might baulk at landing in these kinds of conditions. Inflation is still running too hot for the Fed to douse the market with liquidity and the growth engine is clearly stuttering. If we see growth drop off quickly and the Fed’s monetary levers fail, then we could see a fairly deep recession. Yet there are reasons to believe that the reality will be somewhere between a moderate to a shallow recession. The labour market is still relatively strong, households are in far better shape going into this downturn than they were in the last two crises and central banks can change tack very quickly if we do see a very sharp downturn. The so-called “Fed put” – where the Fed would step in to tackle market distress - no longer exists, but central banks will act to protect households from a truly severe economic crisis.

There are perhaps two ways to look at the environment we’re in: as consumers, and as investors. For the former, there is absolutely no doubt that these are difficult times, and they are very likely to get harder in the months to come. But for investors, it’s not quite that simple. Valuations coming down is good news if you’ve managed to protect capital through the downturn – it gives you more attractive entry points than we have seen for many years. We happen to have steered our client portfolios to that privileged position, and although we think that there is more pain ahead in equity and bond markets, at some point a time will come where we can jump back in, take more risk, and take advantage of a critical opportunity to compound capital for our clients.

On the face of it this is a gloomy time for investors. The macroeconomic quandary is clear; we are probably on the cusp of a recession, but central banks can’t do much about it with inflation running so hot. What’s more, this potential recession is so well signposted that CFOs and business owners are slowing down spending in anticipation of it, further compounding the problem. As we enter the second half of the year, investors are now focused on the outcome of the corporate earnings season - looking for evidence that the slowdown is starting to eat not just into asset prices, but also real company earnings. Any disappointments to analyst forecasts are likely to drive sentiment (and risk assets) lower. All in all, it seems likely that there is a further leg down for risk assets, whether that’s driven by a moderate to severe recession, or by weaker than expected corporate earnings.

Interestingly, while the macroeconomic picture is clearly very weak, that doesn’t necessarily equate to a dismal outlook for investors in financial assets, in fact the reverse can be true. When valuations come down, long term projected returns go up. That doesn’t help you if you’ve already been overly exposed to the downside, but it’s extremely helpful if you’ve protected capital well enough to be opportunistic when the time is right. We have protected capital relatively well in 2022, and while we do think that we are very likely to see another leg down in risk assets, we are also looking for signals that the market could start to bounce back. At which point, we would be poised to take on more equity and credit risk, aiming to capture these assets at attractive long-term entry points. There are perhaps five key events that could materially change market sentiment at the moment: the US Federal Reserve shifting its hawkish stance on inflation, signs of inflation peaking, a reduction in the intensity of the war in Ukraine, the US Dollar weakening and China moving away from its zero covid policy. Any one of these outcomes has the potential to kickstart a shift in sentiment, and we are watching for them closely.

Right now, we think that an asset price recovery is still in our sights, but not quite at the point at which we’d pull the trigger and take on more risk. For now, we think it prudent to protect capital as we enter what is likely to be an even tougher short-term environment for financial assets. Commodities have been an excellent diversifier throughout most of 2022, but we have reduced that position for clients now that the recession risk has increased. We have also added positions in bond call options, tapping into the potential for bonds to rally without taking on the duration risk. We continue to favour the use of active management and hedge fund strategies, that can take advantage of heightened risk and market dislocation.

All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our terms and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.

This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.